Intermediate Accounting II, ACCT 3322 Solutions Review Questions, Chapters 19 and 20

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1 Intermediate Accounting II, ACCT 3322 Solutions Review Questions, Chapters 19 and On December 31, 2002, Spencer Company had 500,000 shares of common stock issued and outstanding. Spencer Company issued a 20% stock dividend on September 1, On October 31, 2003, twenty one thousand shares of common stock were reacquired as treasury stock. Calculate the number of shares that would be used in basic earnings per share for Restated Fraction Weighted Description Dates Shares Restate Shares of Year Average Beginning balance 1/1/03 500, ,000 8/12 400,000 20% stock dividend 9/1/03 100,000 Adjusted balance 600, ,000 2/12 100,000 Purchased treasury stock 10/31/03 (21,000) Adjusted balance 579, ,000 2/12 96,500 Weighted-average common shares outstanding 596, On December 31, 2002, the Spencer Company had 100,000 shares of common stock issued and outstanding. On April 30, 2003, the company sold 150,000 additional shares for cash. Spencer Company's net income for the year ended December 31, 2003 was $900,000. During 2003, Spencer Company declared and paid $300,000 in cash dividends on its nonconvertible preferred stock. Calculate basic EPS for Basic Earnings per share Income available to common shares $600,000 Common shares outstanding 200,000 Basic EPS $3.00 Income available to common shares: Net income $900,000 Preferred dividends 300,000 Income available to common shares $600,000 Page 1

2 Weighted-average common shares: Fraction Weighted Description Dates Shares of Year Average Beginning balance 1/1/03 100,000 4/12 33,333 Sale of shares 4/30/03 150,000 Adjusted balance 250,000 8/12 166,667 Weighted-average common shares outstanding 200, Spencer Company had 200,000 shares of common stock and 50,000 shares of 8%, $100 par value convertible preferred stock outstanding during the year. Net income for the year was $750,000 and dividends were paid to both common and preferred shareholders. Spencer Company's effective tax rate is 40%. Each share of preferred stock is convertible into 5 shares of common. Calculate diluted EPS for Basic Earnings per Share Income available to common $350,000 Weighted-average common shares 200,000 Basic EPS $1.75 Analysis of income available to common: Net income $750,000 Preferred dividends: Par value per share of preferred stock $100 Number of shares outstanding 50,000 Total par value 5,000,000 Dividend rate 8% Preferred dividends 400,000 Income avaiable to common $350,000 Page 2

3 Diluted Earnings per Share Adjusted income available to common shares $750,000 Adjusted common shares 450,000 Diluted EPS $1.67 Adjusted income available to common: Income available to common $350,000 Add back preferred dividends 400,000 Adjusted income available to common shares $750,000 Adjusted common shares: Weighted-average common shares 200,000 Conversion of preferred stock to common 250,000 Adjusted common shares 450,000 Analysis of conversion of preferred stock: Number of shares outstanding 50,000 Conversion ratio 5 Conversion of preferred stock to common 250, Spencer Company had 300,000 shares of common stock outstanding during the current year. At the beginning of the year, options for 25,000 shares of common stock were granted with an exercise price of $25. The average market price of the common stock during the year was $50. Net income was $2 million. Calculate diluted EPS for the year. Page 3

4 Diluted Earnings per Share Income available to common shares $2,000,000 Adjusted common shares 312,500 Diluted EPS 6.40 Adjusted common shares: Weighted-average common shares 300,000 Shares from exercise of options 12,500 Adjusted common shares 312,500 Treasury Stock Method Assumed shares issued 25,000 Exercise price $25 Additional shares 25,000 Assumed funds available $625,000 Assumed funds available $625,000 Average market price $50 Shares assumed purchased from treasury 12,500 Additional shares 12, During the current year, Spencer Company had 1 million shares of common stock outstanding. Ten thousand, $1,000, 8% convertible bonds were issued at face amount at the beginning of the year. Spencer Company reported income before tax of $1,800,000 and net income of $1,170,000 for the year. Each bond is convertible into eighty shares of common. Calculate diluted EPS. Page 4

5 Basic Earnings per Share Income available to common $1,170,000 Weighted-average common shares 1,000,000 Basic EPS $1.17 Diluted Earnings per Share Adjusted income available to common $1,690,000 Adjusted common shares 1,800,000 Diltued EPS $0.94 Analysis of adjusted income available to common: Income available to common $1,170,000 Interest (net of tax) 520,000 Adjusted income available to common $1,690,000 Analysis of interest (net of tax): Face value of bonds $1,000 Number of bonds outstanding 10,000 Total face value 10,000,000 Interest rate 8% Interest expense 800,000 Income tax rate 35% Income tax 280,000 Interest expense (net of tax) $520,000 Analysis of income tax rate: Income before income tax $1,800, % Income tax 630,000 35% Net income $1,170,000 65% Adjusted common shares: Weighted-average common shares 1,000,000 Conversion of preferred stock to common 800,000 Adjusted common shares 1,800,000 Analysis of conversion of bonds: Number of bonds outstanding 10,000 Conversion ratio 80 Conversion of preferred stock to common 800,000 Page 5

6 6. On December 31, 2002, Spencer Company had 180,000 shares of common stock outstanding and 5,000 shares of 8%, $100 par value, cumulative preferred stock outstanding. On April 30, 2003, Spencer Company purchased 15,000 shares of common stock on the open market as treasury stock paying $35 per share. Spencer Company sold 9,000 treasury shares on October 31, 2003, for $37 per share. Net income for 2003 was $229,300. Also outstanding during the year were stock options giving key personnel the option to buy 60,000 common shares at $25. During 2003, the average market price of the common shares was $40 with a closing price of $44 on December 31, Compute basic EPS for Basic Earnings per Share Income available to common shares $189,300 Weighted-average common shares 171,500 Basic EPS $1.10 Income available to common shares: Net income $229,300 Less: preferred dividends 40,000 Income available to common shares $189,300 Analysis of preferred dividends: Par value $100 Shares of preferred stock 5,000 Total par value 500,000 Dividend rate 8% Preferred dividends $40,000 Weighted-average common shares outstanding: Fraction Weighted Description Dates Shares of Year Average Beginning balance 1/1/03 180,000 4/12 60,000 Purchase of treasury stock 4/30/03 (15,000) Adjusted balance 165,000 6/12 82,500 Sale of shares 10/31/03 9,000 Adjusted balance 174,000 2/12 29,000 Weighted-average common shares outstanding 171,500 Page 6

7 Compute diluted EPS for Diluted Earnings per Share Income available to common $189,300 Adjusted common shares outstanding 194,000 Diulted EPS $0.98 Adjusted common shares outstanding: Weighted-average common shares 171,500 Additional shares from options 22,500 Adjusted common shares outstanding 194,000 Treasury Stock Method Shares assumed issued 60,000 Assumed proceeds: Exercise price $25 Number of shares 60,000 Assumed proceeds $1,500,000 Assumed proceeds $1,500,000 Divided by average market price $40 Number of shares assumed purchased 37,500 Dilution (additional shares) 22, Spencer Company granted options for 100,000 shares of its $5 par common stock at the beginning of the current year. The exercise price is $40 per share, which was also the market value of the stock on the grant date. The fair value of the options was estimated at $12 per option. The options are exercisable at the end of three years of service and expire after 10 years of service. (a) If Spencer Company uses the fair value approach, what would be the total compensation indicated by these options? Total Compensation FV of options 12 Number of shares in option 100,000 Total compensation 1,200,000 Page 7

8 (b) Prepare the journal entries to record compensation expense for each for the first three years. Paid-In Capital, Stock Options FV of options 12 Number of shares in option 100,000 Total compensation 1,200,000 Vesting period 3 Annual charge to paid-in capital, stock options 400,000 ACCOUNT DEBIT CREDIT Compensation expense 400,000 Paid-in capital, stock options 400,000 To record compensation expense for first year Compensation expense 400,000 Paid-in capital, stock options 400,000 To record compensation expense for second year Compensation expense 400,000 Paid-in capital, stock options 400,000 To record compensation expense for third year Page 8

9 8. In 2005, Spencer Company changed its method of valuing inventory from the FIFO method to the average cost method. At December 31, 2004, Spencer Company s inventory was $200,000 as reported in the financial statements. Inventory would have been $175,000 at December 31, 2004 if it had been valued using the average cost method. Spencer Company s effective tax rate is 20%. Prepare the journal entry to record the change in accounting principle as of January 1, Retained earnings $20,000 Deferred tax asset 5,000 Inventory $25,000 To record the change from FIFO to average cost Inventory at FIFO $200,000 Inventory at average cost 175,000 Adjustment to inventory 25,000 Income tax rate 20% Income tax effect 5,000 Prior period adjustement to retained earnings $20, At the end of the current year, a company overstated prepaid insurance by $200,000 and understated supplies expense by $100,000. Its effective tax rate is 40%. As a result of this error, net income is overstated (understated) by how much? Insurance expense understated $200,000 Supplies expense understated 100,000 Total expenses understated 300,000 Effective income tax rate 40% Income tax effect 120,000 Net income overstated $180,000 Page 9

10 10. Griggs Company purchased a piece of machinery for $60,000 on January 1, 2004, and has been depreciating the machine using the sum-of-the-years'-digits method based on a five-year estimated useful life and no salvage value. At December 31, 2005 the book value of the machinery was $24,000. On January 1, 2006, Griggs decided to switch to the straight-line method of depreciation. The salvage value is still zero and the estimated useful life is changed to a total of six years from the date of purchase. The effective income tax rate is 20%. Prepare the journal entry to record depreciation for Depreciation expense 6,000 Accumulated depreciation 6,000 To record depreciation expense for the year ended December 31, 2006 Original cost $60,000 Accumulated depreciation 36,000 Book value 24,000 Service life 4 Annual depreciation $6, Fisher Industries changed its method of accounting for bad debts from the direct writeoff method to the allowance method on January 1, The company's accountant determined that an appropriate allowance of $30,000 should be established. The effective income tax rate is 30%. Prepare the journal entry to record the accounting change. Retained earnings $21,000 Deferred tax asset 9,000 Allowance for doubtful accounts $30,000 To record the correction of an error, changing from the direct charge off method (an unacceptable method) to the allowance method (required by GAAP) Allowance for doubtful accounts $30,000 Effective tax rate 30% Deferred tax asset 9,000 Prior period adjustment to retained earnings $21,000 Page 10

11 12. Chestnut Company purchased a machine on January 2, The machine had a cost of $52,000 with a $2,000 residual value. The estimated useful life of the machine was 8 years. On January 2, 2003, due to technological innovations, the estimated useful life was reduced by 2 years from the original life and the residual value was cut by 50%. The company uses straight-line depreciation. Prepare the journal entry to record the annual depreciation on December 31, Depreciation expense $9,625 Accumulated depreciation $9,625 To record depreciation expense for the year ended December 31, 2003 Original cost $52,000 Original salvage value 2,000 Depreciable base 50,000 Service life 8 Annual depreciation 6,250 Number of years 2 Accumulated depreciation 12,500 Book value 39,500 Adjusted salvage value 1,000 Adjusted depreciable base 38,500 Adjusted service life 4 Annual depreciation $9,625 Page 11

12 13. On January 1, 2006, Bubba Construction decided to change from the completed contract method of accounting for long-term construction contracts to the percentage-ofcompletion method. The company will continue to use the completed contract method for tax purposes. The tax rate is 30%. The following are all relevant data concerning the change. Income before Income Tax Year Percentage Completion Completed Contract Before 2005 $500,000 $300, , , , ,000 Prepare the journal entry to record the accounting change. Income before Income Tax Year Percentage Completion Completed Contract Change Before 2005 $500,000 $300,000 $200, , , ,000 Totals $900,000 $550,000 $350,000 Construction in progress $350,000 Effective income tax rate 30% Income tax effect 105,000 Prior period adjustment to retained earnings $245,000 Construction in progress $350,000 Deferred tax liability $105,000 Retained earings 245,000 To record change in accounting principle at January 1, Page 12

13 14. Champion Company's auditor discovered some errors. No errors were corrected during The errors are described as follows: (1.) Beginning inventory on January 1, 2002, was understated by $5,000. (2.) A two-year insurance policy purchased on April 30, 2002, in the amount of $12,000 was debited to Prepaid Insurance. No adjustment was made on December 31, 2002, or on December 31, Prepare appropriate journal entries (assume the 2003 books have not been closed). The effective income tax rate is 25%. No Entry, self-corrected during 2002 Insurance expense $6,000 Income tax receivable 1,000 Retained earnings 3,000 Prepaid insurance $10,000 To correct error in 2002 and record insurance expense for 2003 Cost of insurance policy $12,000 Months in effect 24 Monthly insurance expense 500 Months in Adjustment to prior year expenses 4,000 $4,000 Effective tax rate 25% Income tax effect 1,000 Adjustment to retained earnings $3,000 Months in Insurance expense for ,000 Reduction in prepaid insurance $10,000 Page 13